Monopolies and price discrimination (L9)

Coverage and key readings

Reading:

NS text : 11.2-11.4
additional material in handout on price discrimination
- And… Essay: ‘The Government may want to encourage price discrimination by income’ linked here
- or The Conversation article mentioned below, plus links

Topics:

causes of monopoly (brief)
profit maximization
What’s wrong with monopoly?
Price discrimination: first coverage; types of pd

Should we help companies tailor prices to your wage packet? (The Conversation, 2015)

Article: Should we help companies tailor prices to your wage packet?
With accompanying worked examples
… see also Examples in links, like

Somewhat more formal writeup:

The Government May Want to Encourage Price-Discrimination by Income, University of Essex Discussion Paper

linked

Learning goals

(Topics in more detail)

What are monopolies and what are barriers to entry?
How do monopolies choose prices and quantities?
What are the social (welfare) consequences of monopoly?

What is ‘price discrimination’?
What forms can price discrimination take, and how does it increase a monopoly’s profits?
How does price discrimination affect social welfare, and whom does it help or hurt?
(Very briefly: other forms of imperfect competition)

The basic idea

Recall: under perfect competition

free entry and exit
- \(\rightarrow\) zero long-run economic profit
many many tiny firms
- \(\rightarrow\) firms are price takers
\(\rightarrow\) p=mc
- And in the long run \(p=ATC\) and firms produce at \(min(AC)\)

these are extreme assumptions; theoretical ideal

(Firms with market power might set \(p>mc\))

Opposite extreme: monopoly

A single firm

Barriers to entry \(\rightarrow\) No threat of entry

Can choose price, which becomes the ‘market price’

Still, the more it charges the fewer units demanded. \(\rightarrow\) Chooses a price (or quantity) where MR=MC (like all firms do)

\(\rightarrow\) Produces ‘less than socially optimal quantity’ in order to charge a high price and increase its profit!

Barriers to entry

Technical barriers to entry

IRS/ Diminishing average cost over a broad range of output
- \(\rightarrow\) ‘a natural monopoly’
- (Here multiple firms producing separately are less efficient producers, cannot produce at the lowest cost)

Debatable: Special knowledge of a low-cost method of production, or key resource

Legal barriers to entry.

Patents and copyrights
Exclusive franchise or license (granted by government, by another firm, by a university)
Government support for a dominant firm, discouraging/forbidding others

From the 2016 Massachusetts ballot initiative?

Monopoly profit-maximisation

As always, set Q to maximize \(QP(Q)-C(Q)\)

\(\rightarrow\) optimization where \(MR(Q) = MC(Q)\) (assuming \(P>AC\))

Remember, the ‘volume’ benefit of increasing Q is countered by
- Greater cost (producing more always costs more)
- The need to reduce price (on all units) to get people to buy it

Graphically: Monopoly profit-max

Warning: price is on the demand curve

The deadweight loss of monopoly

Criticisms of monopoly:

Monopolies produce too little output: allocatively (top-level) inefficient.

Less output, higher price than under perfect competition

Some of the consumer surplus under perfect competition is transferred to the monopolist.
There is also a deadweight loss under monopoly

Redistribution from consumers to owners?

Other criticisms: Some argue the DWL above understates the true harm of monopoly

‘Secure’ monopolies don’t innovate as much, and spend wastefully?

Monopolies expend wasteful resources (lobbying, threats, lawsuits…) to preserve barriers to entry? \(\rightarrow\) further deadweight losses

Counters: Monopolies are SR only? Disciplined by potential entry, & have greater incentives to innovate?

Estimates of social cost of monopoly … range from 0.5% to 5% of GDP

Price discrimination (introduction)

Preamble

Price discrimination: 15 Sept 2013, Co-op press release

Ground-breaking supermarket discount for students

Co-operative Food and NUS … announced a ground-breaking deal that will see students … receive a 10% discount on all groceries, at more than 3600 participating Co-operative food stores across the UK.

CJ Antal-Smith, Head of Commercial - Grocery at The Co-operative Food:

’Students are facing increasing financial pressures while studying, and are becoming more savvy when it comes to food shopping.

We wanted to help students, many of whom are living away from home for the first time, to live and cook on a budget."

Why would they do this?

Exeter Picturehouse:

Why such a complicated price list?

What is ‘price discrimination’?

What forms can price discrimination take, and how does it increase a monopoly’s profits?

How does price discrimination affect social welfare, and whom does it help or hurt?

Price discrimination

Price Discrimination: The practice of firms offering different prices to different consumers for the same product,

or different prices for slightly different products or quantities,
- where the price difference doesn’t merely reflect a production cost difference,
- aiming to distinguish consumers’ willingness to pay (WTP).

Why do firms price discriminate?

To increase profit
- by ‘extracting more surplus’ from consumers

In general…

for a monopoly firm, the ability to identify consumers based on their WTP and charge distinct prices will increase profit.

… but it may increase or decrease social (consumer+producer) surplus

Consumer surplus itself may increase or decrease.

The alternative to price discrimination (previous analysis)

‘Uniform pricing’: Offering a single price for a good for all consumers.

This does not deal with differences amongst consumers.
‘Forces you’ to target a particular group (e.g., the wealthy) reducing total sales.
Under monopoly, this leads to a deadweight loss

Price discrimination may seem counter-intuitive: ‘how can offering some consumers lower prices increase profit?’

Higher prices \(\rightarrow\) greater profit per unit; but also higher price \(\rightarrow\) sell fewer units.

The more you charge the less you sell.

Groups of ‘less keen’ consumers are very sensitive to price; would buy little at high price \(\rightarrow\) lower price more profitable here.
Identifiable ‘keen’ consumers buy a lot even at a high price. ‘Less price-sensitive’: higher price more profitable here.

The three types of price discrimination

Individual-based (First degree; at best ‘perfect’)

Self-selection (Second degree)

Group-based (Third degree; ‘market separation’)

First-degree and/or ‘perfect’ price discrimination

The firm can offer each individual a different price for each unit they purchase.

Assuming you know what the consumer is willing to pay, you can make the highest possible profit; that is called ‘perfect’ price discrimination.

Perfect price discrimination: Charging each consumer (for each unit) the maximum he/she would be willing to pay, i.e., her valuation

Here, monopolist extracts all available surplus; no consumer surplus remains

Because monopolists extract all the possible surplus, this is efficient
- Because max(total value of good - cost) \(\rightarrow\) max(CS+PS)

Is this easy to do?

Perfect PD is a rare/impossible extreme: requires mind reading
- Close example: Website targets individualised price to each consumer, using clues like time-of-day, web clicks, cookie data, IP location.

Is this ‘perfect’ PD?

No, it isn’t (see note).

Second-degree price discrimination (self-selection)

Firm cannot differentiate between consumers , uses quality/quantity so consumers self-select.

Quality- Transport- Different classes, Supermarkets- budget products
Quantity- Supermarkets- Larger quantities at lower prices per unit; i.e., ‘nonlinear pricing’

8 oz coffee for 1.60 vs. 16 oz. for 2.00
20 p per oz vs. 12.5p per oz.

With linear pricing there would be the same price of 15p/oz. - Result: with 2 prices monopoly can get ‘high value’ consumers to buy/get more in total without losing ‘low-value’ consumers

Similar with quality: Don’t know who high-valuation flyers are (wtp for travel itself varies)

But may know on average that flyers with higher wtp for travel also value comfort more… thus:

Make second-class seats very uncomfortable, first-class luxurious, and charge more for first-class seats
Can get consumers with higher values for travel and comfort to pay more, without losing lower-valuing customers

The ‘self-selection’ problem

Train companies must price first and second class such that consumers will self-select.

If first class is too expensive then the high valuing group will not choose first class

If second-class is too cheap, both the high and low groups will choose second class

But if second class is too expensive, the low groups will not buy a ticket.

Third-degree price discrimination (3dpd)/ Group based/ Market separation

Third-degree (group-based) price discrimination: The practice of charging different prices to different groups that can be identified by the seller

The firm can differentiate groups of consumers or ‘local markets’, not individuals.

Each group has a different willingness to pay on average

\(\rightarrow\) Offer lower prices to lower-valuing groups, higher prices to higher-valuing groups

Example: Students face lower prices for transport, food and other goods as they have a lower willingness to pay Remember: this is not done out of charity but to boost profits

Pricing under 3dpd/market separation

Each group or market has it’s own demand \(\rightarrow\) marginal revenue curve

\(\rightarrow\) So set an optimising price quantity separately for each group

E.g., a discount for the elderly, higher price for the middle-aged

Or a lower price in Portugal than in Germany

Another depiction, adding demand curves (‘average revenue’):

Who benefits from 3DPD?

Consumers in identifiable group with lower wtp face lower prices, thus they benefit

Consumers in identifiable group with higher wtp face higher prices, thus they lose

Firms can charge higher prices to high-wtp group without losing low-wtp group \(\rightarrow\) increase profit

Net welfare result: theoretically uncertain

For consumers:

Why is the benefit uncertain?

Two factors (may) trade off… Exchange and Top-level efficiency … who eats the quiche vs amount of quiche baked

Exchange efficiency

When ‘low and high valuation’ groups can be identified

high-valuation groups charged more, thus consume less (vs uniform price)
low-valuation groups get charged less \(\rightarrow\) consume more

\(\rightarrow\) Who eats it?: Given what is produced, PD causes it to be consumed by people who value it relatively less!

This is bad, it reduces “exchange efficiency” but…

Production and allocative efficiency: On the other hand PD can lead more to be produced/consumed

E.g., suppose that with a ‘uniform price’ only the wealthy went to a restaurant…

after PD (early-bird, OAP, benefits discounts) the low-income may also dine in the restaurant

\(\rightarrow\) more value is produced

Two effects trade off: negative ‘exchange efficiency’ impact, potentially positive impact on production

…of the otherwise underproduced good (rem DWL of monopoly)i

\(\rightarrow\) top-level efficiency may increase (or decrease)

Bc ‘exchange efficiency effect’ is negative, 3DPD can only be beneficial if quantity increases (necessary but not sufficient condition)

But ‘arbitrage’ can foil price discrimination (see readings)

If, e.g., elderly who get discounts could sell products to middle-aged, can OAP discounts work?…

Middle-aged would ask them to do this, never pay high price
Firm could no longer profit from this

Similar issues with quantity discounts, or ‘web cookie’ personalised pricing

So PD only ‘works’ for hard-to-trade goods like haircuts, or where purchases are frequent & low-value, resale markets difficult

David’s old ‘new’ policy idea:

People with low-incomes tend to have lower-wtp for most goods
Government can typically identify and verify incomes

Governments could allow and encourage low-income consumers to get an ID indicating this
Governments could allow and encourage firms to use this for price-discrimination

Firms would increase profit
Low-income households would benefit, reducing inequality

Net impact on efficiency uncertain; worth investigating?

Natural monopolies and regulation (very brief or skip)

Where an industry involves a ‘natural monopoly’ (IRS) the most efficient production is a unified production process . . .
- But if a monopoly reigns it overcharges and underprovides

\(\rightarrow\) Government may want to allow/enforce monopoly privileges but regulate price it can charge

Difficulty: Government wants to regulate \(p=AC\), but it doesn’t know firms’ actual cost function (asymmetric information)
- Firm wants government to think it is high cost

TIL

Basic ideas about:

…what ‘price discrimination’ is and why firms use it
…what the forms of price discrimination are (1st-3rd degree; perfect, self-selection, market-separation)

…how firms choose prices for separated markets

…what limits price discrimination

…(when) price discrimination helps/hurts social welfare

#(We may skip): IMPERFECT COMPETITION ##(We may skip): IMPERFECT COMPETITION

Brief notes on imperfect competition

With multiple firms in the same market but not complete ‘free entry’, theory predicts a range of possible outcomes.

collusion: ‘patient’ firms may collude to establish monopoly price, or any price above competitive price

‘Cournot’ competition, firms choose quantities: predicts intermediate price, between competitive & monopoly prices

‘Bertrand’ competition in prices: predicts firms compete price down to the competitive (mc) level

Product differentiation, monopolistic competition: may lead to zero long-run profits, with \(p=AC>MC>\) for each firm.